New York Markets After Hours

Fear factors

Investing in the VIX could protect your portfolio in volatile markets

By

JohnSpence

Correction: A previous version of this report misspelled the name of Center for International Securities and Derivatives Markets research analyst Edward Szado.

BOSTON (MarketWatch) -- Stock investors who spread money across other markets such as commodities and real estate didn't get much shelter from 2008's meltdown. But tapping the market's "fear gauge" might have helped.

Investing a small portion in the CBOE Volatility Index
VIX, +5.38%
could have provided some protection from the worst of last year's storm, according to researchers at the University of Massachusetts.

Investable VIX products could have been used to provide some much-needed diversification during the crisis of 2008," wrote Edward Szado, a research analyst for the Center for International Securities and Derivatives Markets at UMass.

British banking giant Barclays (BARC)
BCS, -1.62%
earlier this year introduced a pair of exchange-traded notes based on futures contracts tracking the CBOE Volatility Index, known as the VIX, or the market's fear index.

The ETNs have attracted attention as a way to purchase disaster insurance against market pullbacks, although the products are complex and need to be clearly understood by investors. See earlier column.

ETNs are debt instruments issued by banks that promise to pay an index return, minus fees and taxes. Therefore, investors are exposed to credit risks that they don't have to worry about with exchange-traded funds, or ETFs. ETNs also have different tax treatment. Barclays is selling its ETF unit but keeping the ETN business.

VIX fix?

The S&P 500 lost 37% in 2008, while its value was cut in half from peak to trough as the credit crisis virtually ground the economy to a halt.

Broad commodities indexes dropped by as much as two-thirds last year, and other traditional diversifiers such as commercial real estate and international stocks fell harder than the S&P 500. Correlations jumped as asset classes fell in concert.

"In stark contrast, volatility levels as measured by VIX experienced significant increases and in 2008 repeatedly set new highs not seen since the crash of 1987," Szado noted. U.S. Treasury bonds were also among the few winners last year amid the flight to safety.

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